Inside was an examination of eBay (NASDAQ:EBAY) CEO John Donahoe’s leadership and transformational change, taking the company from online auction house to e-commerce superstar. PayPal, which it acquired for $1.5 billion in October 2002, was instrumental in that change.

By examining eBay’s experience in acquiring PayPal, investors can learn something important about capital allocation.

Why eBay Beat the Odds

Acquisitions are just one of six uses for a company’s free cash flow — dividends, share repurchases, debt repayment, investment in the existing business, and creation of new products or businesses are the others. Of the six, acquisitions (especially large ones) have the least likelihood of adding shareholder value. In fact, many deals end up doing the exact opposite.

So why did eBay’s PayPal deal succeed when so many fail?

Shortly, because the two companies were interdependent. Former PayPal marketing director Eric Jackson wrote in an October 2012 VentureBeat article that 70% of eBay auctions at the time of the acquisition accepted PayPal; a quarter of them used the payment service to close the transaction.

At the same time, eBay was monkeying around with its own payment service in partnership with Wells Fargo (NYSE:WFC), but PayPal clearly was the way to go. Joining together removed a lot of the regulatory risk that PayPal was facing in many states over its money transmitter licenses.

At the time of the deal, critics cried that PayPal didn’t get enough of a premium from eBay. Shareholders received 0.39 shares of eBay for every share of PayPal. The all-stock deal valued the payment service at $23.61 per share, a 15% premium to its closing stock price on the day of the announcement. More puzzling for some is that PayPal’s IPO was just five months earlier — after its first day of trading, the company was worth $1.2 billion on paper. What was the hurry for PayPal to be acquired after all the trouble of an IPO?

Despite having a successful public debut under its belt, PayPal still was very much on shaky ground. Its revenue run rate was $160 million with $80 million in losses. Its second-quarter 10-Q from June 2002 reveals quarterly revenue of $53.7 million, with a small operating loss of $446,000. Meanwhile, eBay’s second quarter generated revenues of $266.3 million with an operating profit of $79.4 million. It would finish 2002 with $1.2 billion in revenue and operating profits of $354 million.

The combination gave PayPal the ability to securely grow its business within a much stronger enterprise; eBay got another revenue driver, although I doubt it knew what it would become. Each side won something by joining forces.

Acquisitions don’t usually go so well, though.

The More Common Story

A classic example of what goes wrong when you combine businesses is the 1985 merger of R.J. Reynolds and Nabisco Brands.

R.J. Reynolds originally began diversifying into the food business back in the 1960s. Its big move came in September 1985, when the second largest tobacco company in America acquired the fourth largest food company for $4.9 billion. The combined businesses generated $19.2 billion in revenue at the time, making it the largest consumer goods company ahead of Procter & Gamble (NYSE:PG).

While that sounded good on paper, the combination brought together two completely different corporate cultures that clashed immediately. Investors didn’t buy into the merger, and RJR Nabisco’s stock languished for months until Ross Johnson, its CEO at the time, got it into a leveraged buyout skirmish (Barbarians at the Gate) so nasty it eventually led to the breakup of the company. Kohlberg Kravis Roberts & Co. (NYSE:KKR), the ultimate winner of the LBO fight, paid $25 billion for RJR Nabisco, and KKR’s investors failed to make any money.

Bottom Line

A little more than 10 years after eBay’s acquisition, PayPal represents approximately 40% of eBay’s revenues (15%-20% at the time of deal) and 31% of operating profits. Revenues grow at 25% annually, operating profits are near 40% growth and free cash flow growth is above 10%. So it’s easy to see why Donahoe is so bullish about the future.

Although I have my doubts about Meg Whitman running Hewlett-Packard (NYSE:HPQ), she had the good sense to bring PayPal into the fold at such an early point in the payment service’s history when it was still vulnerable. And eBay, in hindsight, got a very good deal, paying $1.5 billion for a company that now earns more than that each year.

The lesson for investors?

Acquisitions rarely succeed, and rarer still are those game changers that propel a business into the stratosphere. Ebay can thank its lucky stars the day PayPal came knocking.

We’ll see if Donahoe can work the same magic with GSI Commerce, a builder of online shopping sites for major retailers, which eBay acquired in 2011 for $2.4 billion. While Donahoe is as good an executive as you’re going to find, GSI Commerce wasn’t half the company PayPal was when it was acquired. GSI Commerce had a history of losing money, and while profitable today, it has a lot of work to do before coming anywhere near matching PayPal’s success.

As far as I’m concerned, investors should avoid companies — Berkshire Hathaway (NYSE:BRK.A, BRK.B) excepted — that make large acquisitions. They usually don’t work, and they often cause more harm than good. Tuck-in purchases are fine, but that’s it — successes like PayPal only happen once or twice a decade.

As of this writing, Will Ashworth did not own a position in any of the aforementioned securities.